The Auditor's Slippery Slope: An Analysis of Reputational Incentives

Carlos Corona · Ramandeep S. Randhawa

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Auditing, Earnings Management, Governance Game Theory and Applications Corporate Governance and Financial Management

Abstract

Reputational concerns have commonly been perceived to have a positive effect on auditing firms' execution of their monitoring and attesting functions. This paper demonstrates that this need not always be the case by studying a two-period game of repeated interaction between a manager and an auditor under the assessment of the market for audit services. Regarding reputation as the sole motivator for the auditor, we illustrate how reputational concerns induce an auditing firm to misreport. We investigate the reasons and circumstances under which such misreporting takes place. In particular, a strategic manager can induce the audit firm down a slippery slope, wherein the managerial fraud increases as the tenure of the audit firm progresses, whereas the auditor's fraud reporting probability decreases.

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References

1981Auditor size and audit quality 1980The Pricing of Audit Services: Theory and Evidence 2003Auditor Industry Specialization and Earnings Quality 1986Information quality and the valuation of new issues 2005Auditor Tenure and Perceptions of Audit Quality 1993Auditing Standards, Legal Liability, and Auditor Wealth 1978Refinements of the Nash equilibrium concept 1993Collusion in Hierarchical Agency

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